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Types of External Economies and Cost Curve in Economics

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Types of External Economies and Cost Curve in Economics!

External economies accrue to the individual firms, if the increase in the output of industry lowers the cost curves of each firm in the industry. On the other hand, external diseconomies accrue to the firms, when the expansion of the output of the industry raises the cost curves of each firm.

The long-run average cost curve falls downward in the beginning because of economies of scale, namely, the use of greater degree of division of labour and the specialised machinery at higher levels of output. The use of greater degree of division of labour and the specialised machinery at higher levels of output are called the internal economies.

They are internal in the sense that they accrue to the firm when its own output or scale increases. Besides internal economies, Marshall introduced the concept of external economies which plays an impor­tant role in Marshall’s partial equilibrium theory of value especially in his analysis of equilibrium problem under conditions of increasing returns or decreasing costs.

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Costs of a firm depend not only on its output level but also on the output level of the industry as a whole. External economies and diseconomies are those which accrue to the firms as a result of the expansion in the output of the whole industry and they are not dependent on the output level of individual firms.

They are external in the sense that they accrue to the firms not out of its internal situation but from outside it i.e., from expansion of the industry. Marshall defined external economies as “those dependent on the general development of the industry.” In a more precise manner Jacob Viner has defined external economies as “those which accrue to particular concerns as the result of expansion of output by the industry as a whole and which are independent of their own individual output.”

External economies accrue to the individual firms, if the increase in the output of industry lowers the cost curves of each firm in the industry. On the other hand, external diseconomies accrue to the firms, when the expansion of the output of the industry raises the cost curves of each firm.

Thus, when the industry expands and as a result of it certain external economies accrue to the firms, the cost curves of a firm will shift down as is shown in Figure 19.14. It should be noted that external economies will cause all types of firm’s cost curves—long-run average and marginal cost curves, short-run average and marginal cost curves—to shift down. In Figure 19.14, initially the long-run average cost curve is Lac (thick curve) and as a result of the expansion of the whole industry and the creation of external economies it shifts down to a new position Lac’ (dotted).

On the other hand, when the external diseconomies accrue to the firms as a result of the expan­sion of the industry, cost curves of the firms will shift upward as is depicted in Figure 19.15. In the beginning, the long-run average cost curve is Lac and with the expansion of the industry output and consequent emergence of external diseconomies causes the long-run average cost curve (along with its short-run average and marginal cost curves) to shift upward to a new position Lac’ (dotted).

As noted above in a previous section, internal economies and diseconomies of scale affect the shape that the long-run average cost curve takes; internal economies of scale cause the long-run average cost to fall as output is increased in the initial stage and internal diseconomies of scale cause the long-run average cost curve to rise.

On the other hand, external economies and external diseconomies cause the long-run average cost curve to shift down or up, as the case may be. Moreover, when we are considering the effect of external economies and external diseconomies on the cost curves, it is not only the long-run average cost curve but all short-run and long-run cost curves, whether total, average or marginal, shift together up or down as the case may be.

In this connection, it is also worth noting that shifts in cost curves of a firm are not always, nor necessarily brought about by the expansion or contraction of an industry’s output alone. For instance, a general increase in cost of materials, such as cement, steel, oil, electricity, a general increase in the prices of machinery and equipment, an all-round increase in wages and interest rates in the economy will also shift up the cost curves of a firm.

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Therefore, in economics when we speak of increasing-cost indus­tries and decreasing cost industries, we consider only the effect of expansion of industry’s output on costs of materials, labour, capital equipment etc. incurred by the firms in that industry and rule out any general increase in these costs in the whole economy.

Types of External Economies:

Now, the question arises when an industry grows or expands its output, what types of external economies it generates which reduce the costs of the firms in it.

The chief examples of external economies provided by Marshall are:

(i) “Improved methods of machinery which are accessible to the whole industry”. when it expands,

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(ii) Economies which result from the growth of correlated branches of industry which mutually assist one another and “being concentrated in the same locali­ties” encourage the development of “hereditary skill”, ‘the growth of subsidiary trades supplying it with implements and machinery’

(iii) Economies which are “connected with the growth of knowl­edge and the progress of arts, especially in matters of trade knowledge: newspapers, trades, trade and technical publications.

Like Marshall, Joan Robinson who analysed the phenomenon of increasing returns (i.e. de­creasing costs) in the context of partial equilibrium analysis, provided the following main examples of external economies:

(i) The cases “where the machinery can be bought more cheaply when the industry presents a large market to the machine-making industry” and

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(ii) The cases “where a large labour force is accustomed to work in a certain trade” and develops “traditional skill”.

From the above examples mentioned by Marshall and Joan Robinson we explain below some of important external economies which accrue to the firms and reduce their costs of production when the industry as a whole expands.

1. Cheaper Materials and Capital Equipment:

First, the expansion of an industry may lead to new and cheaper raw materials, machinery and other types of capital equipment. The expansion of an industry means that demand for the various kinds of materials and capital equipment required by it increases.

This makes it possible to produce them on a large scale by other industries. This large- scale production of materials and capital equipment lowers their costs of production and hence their prices. Thus the firms in the industry which use these materials and capital equipment will be able to get them at lower prices. This will favourably affect their costs of production. This, of course, will happen in cases where there are increasing returns (i.e. decreasing costs) in the industries supplying the materials and capital equipment.

2. Technological External Economies:

Secondly, with the growth of an industry some external economies of technological type may accrue to the firms of that industry. In our discussion of returns to scale we mentioned that as an individual firm expands its scale it may become possible for it to use more specialised and productive machinery and to introduce greater degree of division of labour.

These are internal technological economies, which change the technical coefficients of production and improve the firm’s productivity. Similarly, when the whole industry expands, it may lead to the discovery of new technical knowledge and in accordance with that the use of improved and better machinery than before. This will change the technical coefficients of production and will enhance the productivity of the firms in the industry and will reduce their costs of production.

3. Development of Skilled Labour:

Another example of external economies that has been suggested is the development of hereditary or traditional skills among labour. When an industry expands in an area, the labour in that area is well accustomed to do the various productive processes and learns a good deal from the experience.

As a result, with the growth of an industry in an area a pool of trained labour equipped with the traditional skills is developed which has a favourable effect on the level of productivity and costs of the firms in the industry.

4. The Growth of Subsidiary and Correlated Industries:

Another external economy accruing to the firms from the growth of an industry is the growth of subsidiary and correlated industries. These subsidiary and correlated industries may specialise in the production of raw materials, tools and machinery and therefore can provide them at lower prices to the main industry.

Likewise, some specialised firms may come into existence, which process the ‘waste product’ of the industry into some useful product, when the expansion of the industry makes the waste product large enough to make it worthwhile to set up separate plants for transforming the waste products into useful ones. When this happens, then the firms of the industry can sell their waste products at a good price. This will tend to reduce their cost of production.

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5. Improved Transportation and Marketing Facilities:

These external economies are greatly rel­evant when an infant industry grows up in a new territory. In the beginning, transportation and mar­keting facilities both for the purchase of materials and for the sale of its product may not be well-de­veloped. However, the expansion of the industry by the entry of new firms in it may make possible the development of transportation and marketing facilities which will greatly reduce the costs of the firms.

6. Development of Industry Information Survives:

As an industry expands, the firms may form a trade association that distributes information regarding technical knowledge and market possibili­ties about the industry through publication of trade and technical journals with the expansion of the industry the firms may jointly set up a central research institute which will be engaged in discovering new improved techniques for the firms in the industry. Thus, besides providing market information, the growth of the industry may help in discovering and spreading improved technical knowledge.

External Diseconomies:

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We have explained above the external economies which accrue to the firms as a result of the growth of the industry. But, as said above, the expansion of an industry is also likely to generate external diseconomies which raise the cost curves of the firms.

The main example of external diseconomies is the rise in some factor prices when the industry expands and its demand for various factors needed by it increases. The expansion of an industry will definitely raise the prices of those raw materials and capital goods which are in short supply.

Likewise, the expansion of the industry is likely to raise the wages of skilled labour, at least in the short run, since it always takes time for the labour to get training and acquire specialised skill needed in a particular industry.

Since the productive factors such as various types of raw materials, cement, steel, various kinds of machinery and tools and skilled labour are scarce, the increase in demand for them resulting from the expansion in the industry is likely to push up their industry will expand by snatching away the scarce resources from other industries, it will bid up their prices. Thus, in the real world of scarcity, an expanding industry will create more external diseconomies than external economies. Therefore, most industries in the real world encounter rising costs when they expand.